The fundamental component to owning a business is having inventory. Without something to sell you’re more of a non-profit organization than you are a profit making machine. Inventory is what makes the business world go ‘round and keeping track of your inventory is what makes your world go ‘round. If you have poor inventory management or don’t implement a suitable accounting system for your assets then you can end up in real trouble, real quick. Don’t be wondering what happened, instead ask what should I do? Understanding accounting means understanding your business and ultimately means contributing to your overall success. Spend some time learning accounting in this course on accounting concepts for business.
What is Inventory?
Inventory can consist of goods or products purchased from a distributor, or they can be goods or products being manufactured by your company. Inventory items in the process of being built are considered raw materials and the inventory ready for re-sale is considered materials. Basically, if you have intentions of selling a product it’s a part of your inventory stock. Good business practice consists of religious recording what products are in your inventory ready for sale and what goods have already been sold. It’s important to keep track of every single item you have for sale so at the end of your reporting period (usually bi-weekly or monthly) you can check your initial inventory against your sold goods and remaining inventory to discover any discrepancies. Plus, you can see if your business is healthy, as in, if you are making money or not. Read the Importance of Accounting for some more tips on how to promote a healthy business through finance management.
Cost of Goods Sold
Once an item has been sold you move the item to a separate line on your income statement that is called cost of goods sold (COGS). COGS can be calculated by subtracting your ending inventory from the sum of your beginning inventory and purchases. You keep the COGS on a different line so you assess your inventory costs at the end of a determined period.
Inventory Accounting Systems
There are two inventory accounting systems that are used by businesses. They are the perpetual inventory system and the periodic inventory reporting system. As you may have guessed, the perpetual inventory system is constantly updated when the company purchases products (this is considered a debit) and when customers buy products from you (considered a credit). The periodic inventory reporting system is a little more cumbersome as involves actually counting your inventory at the end of the year to compare it against your initial inventory purchase records. Yes, counting out how many pairs of socks or how many specialty dog bones you have left in stock may sound nothing short of awful, but it’s for good reason. Even with perpetually updating your inventory records throughout the year, there could be missing, damaged or stolen products that are unaccounted for. This messes with your COGS and gross profit margin numbers. So really, either way, you should be counting. In the course Accounting in 60 Minutes you can learn more about COGS, profit margins and managing inventory.
Lower of Cost or Market (LCM)
This handy little test set by the GAAP is designed to prevent a business from selling discounted items and then reporting inflated profits for the same time that the discounted products are sold. Sometimes an item you have in stock may suddenly lose value and become cheaply available. When this happens your competitors may take advantage of the lower costs and then re-sell the item at a lower price than your item is set at. You are now forced to lower the price of your product to stay competitive – even if you had originally obtained it for a higher price. This shift in price can cause an unexpected loss in gross profit. Any items remaining at the end of the year should be compared to the market value, or the current replacement value. If this value is less than what you were selling it for originally, the items should be adjusted to meet the market value and recorded. If the market value is higher, the historical cost should be kept and also recorded.
FIFO vs LIFO
There are two popular cost accounting techniques that allow for practical management of inventory. They are first in first out (FIFO) and last in first out (LIFO).
FIFO simply says that any inventory purchased first (so the oldest inventory in stock) will be sold first. This makes sense for most business models as it allows for an inflation gap, higher profits and the likelihood of losing perishable items is substantially lower.
The LIFO method of inventory valuation is much less popular and means the last items purchased (the newest items in stock) are the first items to be sold. This technique leads to messy and confusing cost reporting and is typically only advantageous if the company is seeking lower reportable profits for lower income taxes.
To learn more about these cost flow techniques and buying and selling inventory check out our Introductory Financial Accounting course.
Retailer Inventory Costs
Naturally, as a retailer you have to somehow acquire the goods you are reselling. Regardless if you are making the products in house or if you’re buying them from somewhere you’re going to have to spend money. If you are buying the product for resale the cost you pay is considered the purchase price which also includes any shipping fees and taxes. If you are manufacturing the product you have to account for direct materials, labor and the manufacturing overhead (like facilities and machines). To calculate your gross profit you have to subtract the purchasing price or manufacturing price from the selling price.
So there you have it, a crash course in inventory accounting. It’s important to closely monitor your inventory levels because having too much inventory can tie up monetary assets and create risk of financial loss. On the flip side, you need to have enough products in stock to continue to meet demand. Learn more about finances and accounting for startup businesses with this course.